I loved this simple article about why hedge funds want economies to destroy your economy. What I want to do in addition to the article, is to add some numbers to the concept.
Using some knowledge gained through Wikipedia, and through my day job, here is a brief explanation of what happens.
An organization (be it a company, or a government) needs a loan (let’s say $1m). In return for the loan, they will provide some bonds as a security for the loan. For those who don’t know – a security against a loan is essentially something with a monetary value, which can be sold should the loan not be paid off. A bond is one such security, in this instance we can say that 1 bond is worth $1.
So the scenario is like so – the government of Greece (for example) wants to borrow $1m. In return for the $1m loan, they will issue bonds with a face value of $1 each. The bonds are a legal piece of paper which guarantees that Greece will pay the bond holder $1 come what may.
Now Greece is desperate for this money, and will do anything to get this money so that their ship doesnt do a Titanic. Enter hedge fund A (refered to as HFA from here on). HFA is willing to lend Greece the $1m (for 1m bonds as a security – you would have thought)…. but since HFA knows Greece is desperate for the money, it has its own rules for lending. The first one will ofcourse be a high interest rate on the loan. The second one (quite crucially) is the discount that HFA wants on the bonds.
What the hell is a ‘discount’? Let me explain.
HFA is doing Greece a favour by giving it some money. But since HFA is taking a major risk here (because who knows whether Greece will sink or swim), it wants to discount the face value of the bond. So – HFA will value the Greek bonds as 40c per bond (as opposed to the face value of $1 per bond). Note: if HFA sold these bonds in the market, it will do so at $1 per bond – THIS is the kicker.
So – Greece agrees to the loan. As a result, HFA will lend Greece $1m. Greece will discount the bonds which are each worth $1, and value them at 40c per bond for THIS loan agreement. As a result, HFA will ACTUALLY own 2.5m bonds (each with a market value of $1).
Now – if Greece pays off the loans on time, HFA does not make big money because all they really earn is the interest on their loan.
If Greece defaults however, HFA is in the driving seat to screw Greece.
If Greece defaults, HFA could relieve themselves of the risk of the loan by selling the bonds to someone else – i.e. sell 2.5m bonds. As a result, Greece will now owe the new person $2.5m + interest, as opposed to $1m + interest that it would have owed to HFA (remember – although HFA acquired the bonds for 40c per bond, the market value does not change and is $1 per bond).
Alternatively, HFA could screw Greece better maximize their return from the loan by activating their Credit Default Swap option. This would mean that HFA will ask Greece to pay back the bonds at face value i.e. Greece would have to now pay $2.5m instead of the original loan amount of $1m. Greece are obligated to pay this as part of the Credit Default Swap agreement. In order to do this, Greece will have to sell other assets, or borrow from elsewhere to payback the HFA loan.
What this would do is make Greece’s assets even more worthless, and hence HFA can lend even more to Greece and charge a greater discount on their bonds, and hence – destroy the Greek economy.
Note: Credit Default Swaps are NOT always activated or part of the loan agreements.
{ 0 comments }
